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What happens next? Is this the bottom? You know better than that... Featured

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With Lehman in bankruptcy, AIG about to fail and WaMu and many regional banks about to implode, you can bet your Aunt Petunia's toe nails that CDS default events will be triggered left and right. Remember, the regionals have not crumbled yet, but it will come.

 

Lack of regulatory authorities in the credit insurance market

The valuation of CDS contracts by banks and other institutions are typically done based on highly complex statistical models as they are generally bought and sold in the over the counter (OTC) derivative market. The nonexistence of any exchange or centralized clearing agent where these insurance contracts trade results in their prices not being reported to the general public. Furthermore, as the CDS contracts are sold and resold again and again among financial institutions, an original buyer may not know that a new, potentially weaker entity has taken over the obligation to pay a claim raising doubts about the counterparty failure and the impact on its books.

The lack of regulations and proper settlement mechanisms in the CDS market saw the Aon Corporation (AON) book huge loss on its protection sold to Bear Stearns. Aon, having sold credit protection to Bear Stearns, had hedged itself by purchasing protection from Societe Generale but had to ultimately bear the loss as it was unable recover losses from Societe Generale. 

Bear Stearns provided a loan of US$10 million to a Philippine entity and demanded the borrower obtain a surety bond from a Philippine government agency, the Government Service Insurance System (GSIS). Bear Stearns, to further hedge default risk on the US$10 million loan purchased protection contract from AON for US$0.425 million. AON, to hedge this risk purchased protection from Societle Generale for US$0.3 million believing it made a cool profit of US$0.1 million.

However, as the Philippines entity defaulted and the GSIS refused to pay on the surety bond, Bear Stearns sued AON based on the first CDS contract, which AON lost and had to eventually pay US$10 million to Bear Stearns. AON then went on to sue Societe Generale, and argued that the court's finding in the first action, that a "Credit Event" requiring payment had occurred under first CDS, mandated a similar result with respect to the second CDS. The district court initially ruled in favor of AON, but as Societe Generale appealed, the court ruled in favor of Societe Generale resulting in AON bearing a loss of US$10 million. My analysts have made the case available:  pdf Aon/SocGen case 86.42 Kb and for general reading, see pdf The Basel Committee on Banking joint_forum on Credit Risk Transfer_2008_update.

Now, if one were to multiply this by tens of thousands of transactions and by multiples of billions of dollars, you can begin to see the gravity of the counterparty and credit risk that abounds in the unregulated CDS markets! The court reversed its decision and ruled in favor of Societe Generale, stating that "the terms of each credit swap independently define the risk being transferred." The court parsed the language of second CDS and noted that "the risk transferred to AON and the risk transferred by it was not necessarily identical." AON had sold Bear Stearns protection that expressly included a failure to pay by GSIS as a Credit Event. However, what it bought from Societe Generale was slightly different. The second CDS contained protection against a condition resulting from any act or failure to act by the Government of the Republic of the Philippines or any agency thereof that has the effect of causing a failure to honor any obligation issued by the government of the Republic of the Philippines. The risks for which protection was sold under first CDS and second CDS did not match up. From a legal and practical perspective, this caveat is a potential time bomb for all OTC CDS contracts and transactions that are custom scripted and not cleared through a universal exchange. Although the US banking system is working towards a centralized clearing house for CDS, the current system is a time bomb waiting to be bailed out!

The judgment was that the first CDS contract and the second CDS contract are two separate contracts, the language is slightly different too, so legally, the resolution of the first CDS doesn't automatically grant the similar conclusion to the second CDS. Thus, the judgment to pay Bear Stearns can't be used and referenced for the second lawsuit, as a result, the risk can't be assumed to automatically be transferred. If one were to extrapolate the results of this case to the broader environment, combined with the murky credit risks and liquidity issues in times of duress, it is easy to come to the conclusion that CDS held by banks, hedge funds and large institutions for the purpose of risk management are quite the IMPERFECT hedge.
 

The court concluded and I quote “We therefore conclude that neither the default, which constituted a Failure to Pay under the Bear Stearns/AON CDS contract, nor the Republic's failure to honor its alleged statutory obligation, constituted a Failure to Pay under the AON/Societe Generale CDS contract. For the same reasons, neither event constituted a "Repudiation." They similarly do not satisfy the other definitions of Credit Event enumerated in the AON/Societe Generale CDS contract.
 

Counterparty bankruptcies that can result in a domino effect across the financial system – getting a clearer idea of why Bear Stearns was bailed out!!!

The valuation of CDS insurance contracts on the books of various banks who bought protection will be largely impacted in case of counterparty bankruptcies. Under normal circumstances, a bank believes that it is hedged against the corporate bond exposure as it has bought protection in the CDS market and does not write off the losses on its bond holdings. However, in the event of the counterparty who sold insurance is unable to pay its clams, then the banks needs to book the loses in its account (in addition to the sunk cost of the CDS premium) which could lead to more writedowns and severely dent profitability and in many cases, solvency.

 

The Federal Reserve has been very proactive in fighting the current crisis by slashing interest rates to 2.0% (and arguably negative rates in real terms), opening up discount window to borrowers, and even bailing out financial institutions. The US Federal Reserve committed US$29 billion to back Bear Stearns assets and an additional $30 billion loan directly to Bear Stearns itself, to facilitate JP Morgan Chase’s purchase of the stricken investment bank for US$2 per share – later increased to $10 per share due to shareholder led derision. The US Fed helped JP Morgan Chase bail out Bear apparently because they stood to lose the most from a Bear Stearns bankruptcy. For example, as Barry Ritholtz of the Big Picture points out, JP Morgan has the greatest derivative exposure of any of the investment banks and it is believed that it had huge exposure toward BSC as counterparty.

 

If Bear Stearns was the counterparty (insurer) to JP Morgan on much of its mortgage-backed security portfolio, it then becomes apparent why JP Morgan had to step in. To avoid a Bear Stearns bankruptcy so that they would not be forced to take toxic assets back onto their own balance sheet and avoid massive write-downs. If JP Morgan Chase‘s exposure towards Bear Stearns was large enough, then JP Morgan Chase itself could have been left significantly impaired.

 

Counterparty risk exposure of various commercial and investment banks

The credit insurance CDS market is generally bought and sold over the counter making it difficult to exactly grasp the depth of the markets. Moreover, the parties involved in the transactions are not disclosed making it impossible for any lay man to measure the amount of risk transferred and who bears it. However, the Office of the Comptroller of Currency (OCC) Quarterly Report on Bank Trading and Derivatives Activities provides an insight into the credit derivatives market.

According to the OCC, banks witnessed trading losses to the tune of US$9.97 billion in 4Q 2007 as compared to trading income of US$2.3 billon in 3Q 2007 and US$3.9 billion in 4Q 2006. This loss, the first ever quarterly trading loss for the banking industry as a whole, is attributable to weak trading results, and reflects unprecedented turmoil in the markets, particularly for credit trading.

 

 

Top 25 commercial banks and trust companies in derivatives (as of 31 December 2007)

RANK 

 BANK NAME 

TOTAL ASSETS 

TOTAL CREDIT  DERVATIVES 

Total credit derivatives bought

Total credit derivative sold 

Credit derivatives as a % of Total assets

Bought credit derivative as a % of total assets

1

JPMORGAN CHASE BANK NA 

1,318,888

7,900,570

4,033,869

3,866,701

599%

306%

2

CITIBANK NATIONAL ASSN 

1,251,715

3,161,349

1,633,975

1,527,374

253%

131%

3

BANK OF AMERICA NA 

1,312,794

1,612,676

1,505,763

106,914

123%

115%

4

WACHOVIA BANK NATIONAL ASSN 

653,269

419,495

208,884

210,611

64%

32%

5

HSBC BANK USA NATIONAL ASSN 

184,492

1,252,423

602,180

650,243

679%

326%

6

WELLS FARGO BANK NA 

467,861

2,766

1,880

886

1%

0%

7

BANK OF NEW YORK 

115,672

2,261

2,259

2

2%

2%

8

STATE STREET BANK&TRUST CO 

134,002

238

238

0

0%

0%

9

SUNTRUST BANK 

175,108

1,177

819

358

1%

0%

10

PNC BANK NATIONAL ASSN 

124,782

6,056

3,956

2,100

5%

3%

11

MELLON BANK NATIONAL ASSN 

39,674

0

0

0

0%

0%

12

NORTHERN TRUST CO 

58,398

279

279

0

0%

0%

13

KEYBANK NATIONAL ASSN 

95,862

8,100

4,347

3,753

8%

5%

14

NATIONAL CITY BANK 

138,755

2,238

1,385

854

2%

1%

15

U S BANK NATIONAL ASSN 

232,760

1,054

425

628

0%

0%

16

MERRILL LYNCH BANK USA 

78,052

8,728

8,728

0

11%

11%

17

RBS CITIZENS NATIONAL ASSN 

128,863

241

219

23

0%

0%

18

REGIONS BANK 

137,050

202

72

130

0%

0%

19

LASALLE BANK NATIONAL ASSN 

74,424

2,255

709

1,546

3%

1%

20

BRANCH BANKING&TRUST CO 

127,698

182

10

172

0%

0%

21

FIFTH THIRD BANK 

61,463

237

68

168

0%

0%

22

FIRST TENNESSEE BANK NA 

36,726

0

0

0

0%

0%

23

UNION BANK OF CALIFORNIA NA 

55,157

0

0

0

0%

0%

24

DEUTSCHE BANK TR CO AMERICAS 

35,425

5,101

5,101

0

14%

14%

25

LEHMAN BROTHERS COML BK 

5,834

0

0

0

0%

0%

Source: OCC fourth quarter bank trading and derivative activity report

  image023.gif

 Source: OCC fourth quarter bank trading and derivative activity report

 

JP Morgan Chase, Citibank and Bank of America have the largest credit derivative exposure followed by HSBC bank and Wachovia Bank. Considering only the credit derivatives bought positions of the various banks, HSBC bank and JP Morgan Chase credit derivative exposure as a percentage of total assets is significantly higher at 326% and 306%, respectively.

  image024.gif

Top Reference Entities Year End – 2006 by Gross Sold and Gross Bought Protection by Notional Amount

  image025.jpg

Source: Fitch Ratings

 

Automobile Majors such as General Motors, Daimler Chrysler and Ford Motors top the list of reference entities on whom the CDS insurance contracts have been written.

 


Top Reference Entities Year End – 2006 by Gross Sold and Gross Bought Protection by Trade Count

image026.jpg

Source: Fitch Ratings

 

On a trade count basis, financial institutions such as Fannie Mae, Deutsche Bank and Merrill lynch are among the top 25 reference entities. 

 

 

Reference Entity by type - 2006

  image027.gif

The analysis of the breakup of the type of reference entities brings out an interesting observation as 8% is accounted for by the structured finance products category. Corporates account for 63% while financial institutions for 23%. 

 


Top 20 counterparties 2006 by Notional Amount – who bears the ‘ultimate risk’

image028.jpg 

Source: Fitch ratings


Morgan Stanley, Deutsche Bank, Goldman Sachs and JP Morgan Chase are the top four counterparties – these are names who have so far been perceived as “too big to fail”. However, given the way this crisis has unfolded, these are the parties who will be bailed out (if required) to prevent a systemic meltdown. The Bernanke led Fed has made it crystal clear that they are willing to use their balance sheet to prevent the natural, albeit potentially disorderly effects market forces on this country’s fifth largest bank and 9th largest counterparty. Just imagine what may lay in store for the new purchasers of Bear Stearns or the Street’s Riskiest Bank, who happens to sit at the top of this list (I don’t call it the riskiest bank on the street for nothing). For those who are not regulars to the blog, we have went into detail on both of these banks (with a significant warning of failure) as well as an overview of the credit situation months before the collapse of Bear Stearns: 

Read 5132 times Last modified on Tuesday, 13 January 2009 01:53
Reggie Middleton

Resident Contrarian Badass at BoomBustBlog (you can call me Editor-in-Chief)...

Disruptor-in-Chief at Veritaseum.com, where we're ushering the P2P Economy.

 

www.boombustblog.com
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